Pros & Cons of Tax Free Municipal Bond Funds

by Mack Mitzsheva

An investor looking to diversify can consider various types of bonds and bond funds. A municipal bond is issued by a state or a local government, such as a city or county, for the purpose of raising capital. A specific municipal bond is often an attractive choice since it's generally a completely tax-free investment for anyone who lives in the jurisdiction that issued the bond, and it is usually federally tax free as well. Mutual bond funds, on the other hand, may contain thousands of bonds from may different locations, which may affect their tax-free status. Muni bond funds also carry other considerations that investors should be aware of.

Background

The capital raised from a municipal bond is sometimes issued to raise money for general governmental expenses, and is backed by general tax revenues. Often, however, it is earmarked for very specific purposes. The funds from a municipal bond, for example, may be used to finance public works projects, such as bridges, roads and low-income housing. In some cases, these specific issue bonds are backed by the issuing agency's general taxing power, which means that the bond's triple tax-free status is clear -- it is tax free locally, at the state level and at the federal level for anyone who lives in the district that issued the bond. Other specific issue bonds, however, may be issued to pay for very specific projects that are expected to generate their own revenue, and the bonds will be repaid from this revenue. Bonds issued to cover such entities -- known as revenue bonds -- may be issued to pay for the construction of such things as hospitals or sports stadiums, and they may or may not enjoy the tax-free status of a general issue municipal bond. A municipal bond fund is a mutual fund that may be composed of a mix of revenue and general issue bonds. It may contain bonds from only one region, such as a state. Or it may contain bonds issued by many states and municipalities, with a mix of revenue bonds and general obligation bonds. You will need to read the prospectus carefully to see what kind of bond you are buying, since the various types may carry very different tax consequences.

Pros

One of the benefits of a municipal bond fund is that the fund's portfolio is professionally managed and owns hundreds of different municipal bonds, so the fund gives the investor a diversified investment. Also, municipal bond funds often have a low point of entry. This means that the initial investment to participate in a municipal bond fund is smaller than investing directly in municipal bonds as an individual, which often requires a minimum initial investment of $5,000. Also, bonds are considered safe investments since municipalities rarely file for bankruptcy.

Cons

Municipal bond funds are assessed fees to cover the management of the fund. Investors also pay fees when bonds are bought and sold. Although bond funds carry minimal capital risk, there is still risk present nonetheless. As interest rates go up, the value of the bonds in the fund declines. This also leads the share price of the fund to drop. Unlike individual bonds that pay the owner the full face of the bond at the time of maturity, municipal bond funds do not have maturity dates. The fund contains various bonds with varying maturity dates, and in a high-interest-rate environment, the rising interest rates could mean the investor may not recover the full amount of the initial investment at the time the shares are sold.

Local Concerns

If you live in a low-population state that doesn't generate a large number of locally issued tax-free municipal bonds, such as Montana or Rhode Island, you may be unable to find a municipal bond fund that generates totally tax free income because you won't find a fund that is composed entirely of general obligation bonds that are issued entirely within your state. If you live in a state with high local income taxes and you buy a municipal bond fund that is largely invested in taxable revenue bonds or in bonds issued by other states, your tax benefit may not be high enough to compensate for the fund's relatively low interest yield.

Local Tax-Free Interest

On the other hand, if you live in a large state with high income tax rates that generates lots of reasonably secure municipal debt, such as New York or Illinois, you may be able to access significant tax savings by investing in a municipal bond fund that specializes in your state.

Considerations

As with all investments, deciding which municipal bond fund to invest in requires an understanding of the investment product. If you're unsure how well an investment in a municipal bond fund will benefit you, consult a bond broker, financial advisor or other investment professional who has experience working with municipal bond funds. This professional can give you advice on how well this investment works for your particular financial situation and recommend funds that are best suited for your long-term goals and expectations based on the investable income you have on hand.

Resources

About the Author

Mack Mitzsheva is a tax lawyer, personal finance expert and the author of the forthcoming ebook, "10 Best Places to Work Online." Mitzsheva is also a social media entrepreneur with five successful sites under her belt. Always innovative, Mitzsheva is currently developing a cutting-edge budgeting app for newlyweds.